Nick Sketch: investment trusts with an edge in income

Four themes have deterred income-seekers from investing in investment trusts (ITs) in recent times:

1) ITs look more than usually expensive in discount terms.

2) The most expensive ITs tend to be those with a good income yield.

3) ITs have obvious advantages but income-seekers rarely need (say) a Brazilian small cap fund

4) Onshore ITs typically have an unhelpful tax treatment on bond income

Does this mean income-seekers can ignore investment trusts at the moment? As with almost every important investment question, you won’t go far wrong saying ‘it isn’t as simple as that’. Or, as Mark Twain put it: ‘All generalisations are false, including this one.’

First, what matters most when picking any active fund should be the management quality and the portfolio. If Findlay Park American, say, were an IT, it probably wouldn’t change its attractiveness much. This reasoning encourages loyalty to many ITs too.

Second, ITs often have revenue reserves, and some can use their structure (for example, cheap debt or ZDPs) to boost income yield. The importance of smoothing dividends can be overstated and a long-term policy of turning capital into income at the margin is hardly tax efficient.

However, IT income reserves can mean a manager can buy a stock that does not meet an income target this year in the expectation it will do well over three or four years. That extra flexibility can be useful, particularly if (as today) many equities yielding 5% look expensive compared to those yielding 3%.

Third, ITs are often the best ways to invest in niche areas, particularly if liquidity in the underlying assets is a problem. This matters a lot at the moment.

In part, this reflects that a lot of UK dividends come from about 20 shares. This doesn’t give much diversification, and few look very cheap today.

More generally, diversifying an equity portfolio is always important but is harder than it used to be, most obviously because cash and mainstream bonds offer very low returns.

Options for investments that should not behave much like equity markets over the next five years include niche fixed interest areas, commercial property and infrastructure. In all these areas, income yields of well over 4% are readily available. And in all these areas, the best investments will often turn out to be ITs.

Of course, we still need to think about valuation – discount swings bring volatility and can hurt even long-term investors, but this point alone makes many ITs worth investigation by income-seekers.

In fixed interest, liquidity constraints mean most unit trusts (UTs), particularly the most successful in asset-gathering, stick to mainstream bonds. However, the recent performance and return prospects of ITs such as Twenty Four Income and City Merchants High Yield, show there is a good reason for investors today to look beyond the obvious, even in fixed interest.

Investments like these will not behave like gilts, particularly over the short term, and we wouldn’t call them low risk. However, an investor who made the sensible decision a year ago to back the Invesco bond team by buying their main UT would have outperformed that fund’s peer group by a percent or two.

Someone doing a bit more work and deciding it was a good time to buy City Merchants instead would have added over 10% to the one-year return – so much for low returns from fixed interest.

Commercial property appeal

In commercial property, investors appear to have been very fearful of leverage a year ago, even though most of us are happy to gear property ourselves (we have mortgages).

A good year for net asset values has meant geared investments outperformed and got rerated, and most property ITs that look cheap today deserve their ratings. However, ITs still have some structural advantages for a long-term investor in property, whether they have high gearing or not – investors will not fund themselves locked in for a year or more if sentiment moves against the sector and funds do not need to hold 10% or even 20% in cash (as many property UTs do today).

Infrastructure investments are also hard to reach via UTs. The reality is that our taxes are paying a return to investors and the sector offers predictable revenues, high yields and some protection from inflation.

With the supply of new assets apparently continuous, care needs to be taken over timing purchases to avoid an unsustainable premium in the price paid, and this sector is not risk-free, but income yields of 5-6% (and long-term total returns probably 1% or 2% higher) can justify their place in many portfolios, particularly if income-biased or tax-sheltered.

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